Chapter 17 Does Debt Policy Matter? 453
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Think of the financial manager as taking all of the firm’s real assets and selling them to investors as
a package of securities. Some financial managers choose the simplest package possible: all-equity
financing. Some end up issuing dozens of debt and equity securities. The problem is to find the
particular combination that maximizes the market value of the firm.
Modigliani and Miller’s (MM’s) famous proposition 1 states that no combination is better
than any other—that the firm’s overall market value (the value of all its securities) is indepen-
dent of capital structure. Firms that borrow do offer investors a more complex menu of securi-
ties, but investors yawn in response. The menu is redundant. Any shift in capital structure can
be duplicated or “undone” by investors. Why should they pay extra for borrowing indirectly (by
holding shares in a levered firm) when they can borrow just as easily and cheaply on their own
accounts?
MM agree that borrowing raises the expected rate of return on shareholders’ investments. But
it also increases the risk of the firm’s shares. MM show that the higher risk exactly offsets the
increase in expected return, leaving stockholders no better or worse off.
Proposition 1 is an extremely general result. It applies not just to the debt–equity trade-off but
to any choice of financing instruments. For example, MM would say that the choice between long-
term and short-term debt has no effect on firm value.
The formal proofs of proposition 1 all depend on the assumption of perfect capital markets.
MM’s opponents, the “traditionalists,” argue that market imperfections make personal borrowing
excessively costly, risky, and inconvenient for some investors. This creates a natural clientele will-
ing to pay a premium for shares of levered firms. The traditionalists say that firms should borrow
to realize the premium.
But this argument is incomplete. There may be a clientele for levered equity, but that is not
enough; the clientele has to be unsatisfied and willing to pay more for levered equity than MM
would predict. There are already thousands of levered firms available for investment. Is there still
an unsatiated clientele for garden-variety debt and equity? We doubt it.
Proposition 1 is violated when financial managers find an untapped demand and satisfy
it by issuing something new and different. The argument between MM and the traditional-
ists finally boils down to whether this is difficult or easy. We lean toward MM’s view: Finding
unsatisfied clienteles and designing exotic securities to meet their needs is a game that’s fun to play
but hard to win.
If MM are right, the overall cost of capital—the expected rate of return on a portfolio of all
the firm’s outstanding securities—is the same regardless of the mix of securities issued to finance
the firm. The overall cost of capital is usually called the company cost of capital or the weighted-
average cost of capital (WACC). MM say that WACC doesn’t depend on capital structure. But MM
assume away lots of complications. The first complication is taxes. When we recognize that debt
interest is tax-deductible, and compute WACC with the after-tax interest rate, WACC declines as
the debt ratio increases. There is more—lots more—on taxes and other complications in the next
two chapters.
MM’s theory boils down to saying, “There is no magic in financial leverage.” Danger lurks
where naïve financial managers try to add value simply by “levering up.” MM did not say that
borrowing is a bad thing, but they insisted that financial risk offsets the higher average returns
from financial leverage. Do not ignore financial risk. Watch out especially for hidden leverage, for
example, from financing leases or pension obligations.
● ● ● ● ●SUMMARY
The fall 1988 issue of the Journal of Economic Perspectives contains a collection of articles, including
one by Modigliani and Miller, that review and assess the MM propositions. The summer 1989 issue
of Financial Management contains three more articles under the heading “Reflections on the MM
Propositions 30 Years Later.”
● ● ● ● ●
FURTHER
READING